Is Smart Indexing A Good Investment Strategy?

Smart Indexing is becoming a more widely accepted investment strategy thanks to its intuitive philosophy of holding an equal exposure of sectors across the board. The status quo for benchmarking performance is to compare one’s equity returns to a broader index like the S&P 500. Because the S&P 500 is market capitalization weighted, exposure to certain sectors such as Technology after a bull run could pose risk to your portfolio. With Smart Indexing, the investor is constantly maintaining a more balanced exposure to equities.

Personal Capital supports the strategy of Smart Indexing because we believe it provides a better risk-adjusted return on investment. Unlike algorithmic money mangers who run investment portfolios through a machine to provide recommendations, Personal Capital employs a team of highly qualified individuals who help manage their client’s money through a multitude of life scenarios.

Let’s say you want to figure out the best way to save for your newborn’s college education. A Personal Capital advisor can help walk you through the steps and allocate your money appropriately. Let’s say you’re changing jobs and want advice on whether you should rollover your 401k, use the 401k for a downpayment on a house, or simply leave the plan as is. A Personal Capital advisor can highlight the pros and cons of each scenario. Or perhaps you’re retired after a fruitful 40-year career and would like to figure out the best investment strategy to make your money last a lifetime and leave some of your wealth to your grandkids. A Personal Advisor is there to structure your portfolio with various scenario outcomes to give you confidence that your goals are met.

WHAT IS SMART INDEXING (AKA SMART BETA/TACTICAL WEIGHTING)?

Beyond the benefits of concierge financial service, I want to highlight the concept of Smart Indexing as used by the Personal Capital team to help clients improve financial returns. I sat down with Craig Birk, Executive VP of Portfolio Management and Kyle Ryan, Executive VP of our financial advisory team in San Francisco and Denver to learn more.

Imagine a scenario where you could reduce risk and volatility while increasing your returns over time. Such is the goal of Smart Indexing. For the US stock portion of portfolios, instead of following a market cap weighted approach to indexing like the S&P 500 index does, Smart Indexing strives to have a more balanced weighting across all sectors and styles. Let me focus on the sector part given it’s a little more intuitive and easier to understand.

The below chart demonstrates equal 10% weightings in 10 US sectors. If you were to follow the S&P 500 index as a benchmark for performance, you would be overweight Technology, Financials, and Health and significantly underweight Communication, Materials, and Utilities. You might think that being overweight Technology is a good idea because it’s a higher growth sector than say, the Utilities sector. However, you never know when the hot sector may turn cold.

Slide 1:

Take a look at the slide below to see what happened to the Technology sector from 1998-2002 and the Financial sector from 2004 to 2008. If your portfolio was market cap weighted with an estimated 29% weighting in Technology, your portfolio severely underperformed a Smart Indexed portfolio. The same goes for owning too much Financial stocks in 2006. The market has a great way of reverting to the mean. Smart Indexing also takes a more balanced approach to size (small, mid and large companies) and style (growth, core and value).

Slide 2:

You might now be wondering how does a Smart Indexed fund perform during a bull market? Shouldn’t one continue to press their momentum bets until something changes? After all, who wants to own sleepy Utility and Telecom stocks in a bull market when tech stocks continue to rip higher thanks to blockbuster acquisitions by Facebook and blazing IPOs like GrubHub? I wondered these same questions myself so I asked Kyle and Craig to show me evidence to the veracity of the Smart Indexing methodology.

The following slide shows two things: 1) Actual results between 9/30/11 to 12/31/13 of our Smart Indexed portfolio compared to the S&P 500 that produced 5.6% absolute outperformance with slightly lower volatility, and 2) Based on our backtesting of a $500,000 portfolio that began in 1990, one would have $1,576,588 more in their portfolio using a Smart Indexing approach vs. a market cap weighted approached. I don’t know about you, but there are a lot of nice things and experiences I could buy with an extra million and a half dollars.

WHY DON’T MORE INVESTORS SMART INDEX INSTEAD?

Smart Indexing is a good alternative to just blindly following the S&P 500 index as a benchmark for exposure to stocks. Until coming to Personal Capital, I never once questioned why following the broadest market index might not be the optimal benchmark due to group think. Everybody does it, so why change?

Now that I understand the merits of Smart Indexing, I believe there are three main reasons why more people don’t employ the Smart Indexing strategy:

1) People don’t know that such a strategy exists.

2) People don’t have time to constantly monitor and rebalance their portfolios.

3) People think they know more about the future than they really do.

Now that you’ve read this article about Smart Indexing, you can cross #1 off the list. You should also cross #3 off the list because we all know you can’t beat the market over the long run by stock picking or jumping in and out (even venerable Warren Buffet has underperformed the S&P 500 recently). Unless your are a professional money manager, or have hours every day to monitor your portfolio, conducting an active management strategy is not in your best interest long term. It’s much more efficient to spend time doing the things you are good at to maximize wealth and happiness.

The solution to crossing #2 off the list is to simply hire someone to monitor and rebalance your portfolios for you. No matter how much experience I have in finance, I’d much rather be writing, traveling, and spending time with my family than checking my portfolio every day for risk exposure. In fact, if I had let Personal Capital manage my IRA, I would likely be ahead year-to-date instead of down 15% thanks to a collapse in high-flyers such as LinkedIn, Netflix, and Sina. There’s more research that shows how equal-weighted indexes perform better than market cap-weighted indexes if you’re interested.

THINK DIFFERENTLY

For the average person, it’s just not worth trying to spend time making money with money for short-term gains. It’s an empty feeling that gets exacerbated when you start losing money because you’re reminded of your stupidity as well as your lighter retirement account.

If you’re looking for a new way to invest and have a tendency to think you’re smarter than you really are, Smart Indexing looks like a solid investment alternative. Not only will your Personal Capital advisor come up with the best financial strategy to suit your needs, they will also help you diversify across multi-asset classes, dynamically rebalance your portfolios, and tax optimize when appropriate. Click here to sign up for Personal Capital’s free financial dashboard and request to speak to an advisor today.

What are your thoughts about continuously investing in equal weightings across sectors vs. a market-cap weighted approach? Is it fair to say that the Smart Indexing approach is more appropriate for conservative investors even though the performance in this post shows that performance is greater?

Disclosure: The Tactical Weighting Strategy shows hypothetical index results, and does not reflect an actual account or trading. Nor does it reflect the impact of fees and expenses that would be incurred by a managed account or fund attempting to follow an indicated index strategy. It is not possible to invest directly in an index or strategy without fees and expenses. Based on available data, the hypothetical results are time linked equal returns of size, style and sector indexes. From 1991 to 1995, it is an average of equal weighted S&P sectors and an equal weight of the S&P 500 and Russell 2000. From 1996 to 2011, it is an average of equal weighted S&P sectors and the nine Russell Style box indexes. Standard deviation is only inclusive of full year return figures. Results assume the reinvestment of dividends. Past performance is no guarantee of future results. Transaction costs, management fees, taxes and other factors, all of which would impact returns, are not considered in the analysis. It is not possible to invest directly in an index or strategy without incurring fees and expenses. All investments involve risk of loss. There can be no assurance that any strategy will be profitable, or that the portfolios described above will perform better than the S&P 500 or other market-weighted index.Actual Performance: Actual Result is performance for our Tactical America strategy, a US equity only strategy. For the calculation, 2012 results were calculated as an average of actual client portfolio returns within the strategy. Only accounts trading for the full calendar year with no material additions or withdrawals were included. For the composite, returns are derived by linking respective quarterly returns. Past performance is not a guarantee of future return, nor is it necessarily indicative of future performance. Performance is shown net of fees and reflects the reinvestment of interest and dividends. Accounts in the composite are billed on a tiered fee schedule and larger
accounts generally pay a lower overall fee rate than other accounts. Accounts with greater than ten percent individual custom restrictions resulting in greater than two percent difference in performance results were not included. Individual account performance will vary depending upon the amount of assets under management and the timing of any additions and withdrawals and may be higher or lower than the performance depicted. [Advisory fees for the accounts included in the performance data ranged from annual rates of 0.75% to 0.95%, depending on the size of the account. Performance for employee and other affiliated accounts has been
recalculated to reflect the standard fee schedule rather than the discounted fees
paid by some of those accounts.

18 Comments

According to CNBC;”Smart beta strategies vary, but they have one thing in common: Size doesn’t matter. Some smart beta funds weight the portfolio according to fundamentals like earnings, dividends and cash flow; others weight it to low volatility or upward price momentum. The simplest and oldest smart beta strategy is equal-dollar weighting: investing the same amount of money in every company in an index, large or small.” (http://www.cnbc.com/id/101149598)

My take is that the indexing approach in general is superior than trying to pick winning stocks and/or managers. Additionally, as Fama and French found, value stocks usually outperform the indexes in the long run.

If smart beta can titrate a portfolio so that it minimizes overvalued holdings/sectors and maximizes undervalued holdings/sectors, that is a positive approach.

Certainly the empirical research will decide after the fact which approach(es) prevail over the long term.

There’s certainly a lot of conversation in the investment community about this new take on indexing. Nice article!

Nice post Sam. I think this approach as merit, but I am always leery about putting too much weight on back-tested results. That said I do use back-testing as one tool in building client portfolios. My question is this, does the Personal Capital smart indexing approach involve the use of ETFs or index funds tailored to these various segments as a means to implement this strategy?

There are two items in the results of the last chart. One is the insert box where the actual Smart Indexed portfolio has outperformed by over 5% over a five year period. The second portion of the chart is the backdated portfolio, which I agree, one can never know for sure.

For me, the concept of Smart Indexing does make sense, and I’ve simply presented it as an alternative to simply following the S&P 500. I don’t know if many people realize that the S&P 500 is market cap-weighted, and how weightings can get overgrown over time.

The final chart comparing the Tactical Weighting to the S&P 500 seems deceptive. According to the disclosure, the Tactical Weighting includes both Large and Small Cap exposures while the S&P 500, of course, only includes Large Cap exposures. Why not compare the Tactical Weighting to the total US market? To use VTI as an example, the benchmark could be DJ US Total Stock Market Index, MSCI US Broad Market Index or CRSP US Total Market Index. I don’t have the numbers since 1990 in front of me but Small Cap tends to outperform Large Cap over the long term. I suspect the Tactical Weighting would not look as favorable if a total market index were used as the benchmark. This might not be a case of out-performance but, instead, a case of bad benchmarking.

I’m as skeptical as they come about anything in finance as someone who worked in finance for 13 years. There are a lot of new products that have come and gone (130/30 anyone).

But intuitively, Smart Indexing makes sense if you want to reduce volatility and still participate in equities. The trouncing of tech, internet, and biotech stocks in March/April of 2014 highlights the dangers of being too overweight the sector after their large runs in 2013.

This makes a lot of sense. I agree that rebalancing is a pain and not something you want to have to keep track of and do yourself. I certainly don’t want to spend time doing that myself. Thanks for highlighting this strategy and explaining it so well! I love learning new things.

I was really surprised to learn after doing research on Smart Indexing why more people doing try this method since it does make sense, and it is a more conservative approach for those looking for less volatility.

I think it’s worth allocating at least a portion of one’s exposure to Smart Indexing.

If one adopts an asset allocation
framework that incorporates non-normality of investment returns (basically all the asset classes you are using), then standard
deviation becomes ineffective as the primary quantifier of portfolio risk. You would better serve potential clients with maximum drawdown and Ulcer Index calculations. You are promoting “tactical weighting” in which there are times when portfolios are underwater for 3-4 years! There are Absolute Return strategies out there that produce better returns over most periods and have single digit max (monthly) drawdown. More “modern” portfolio theory. Long-only diversification and ill-timed re-allocations are all too common.

You implied that Smart Indexing, AKA, Smart Beta/Tactical Weighting, could “reduce risk and volatility while increasing your returns over time.”

That statement is not entirely true. While it does increase your return over time, it does not reduce the risk or volatility.

The concept behind smart beta is fundamentally flawed, because it increases the return by increasing the risk. In other words, it doesn’t increase the return by maintaining the same risk.

It is wildly known that smaller companies perform better than larger companies over time because of the additional risks associated with smaller companies. By equal weighting the index, you are inherently increasing the risk of the index.

How can “Smart Indexing” reduce risk, as measured by the beta, when it’s putting more emphasis on the smaller companies (although still big) in the index?

The equal-weight index has an average market cap of $16 billion (maybe higher now), versus the average market cap of $58 billion (maybe higher now) in the cap-weight index. It’s widely known that smaller companies are riskier, therefore they have higher returns.

Nearly half of S&P 500 is categorized as mad-cap by Morningstar, so an equal-weight S&P 500 simply has more mad-cap exposure than cap-weight S&P 500.

That’s how the excess return is explained. Smart Alpha is supposed to increase the return without increasing the risk. Equal-weight simply increases the risk and therefore return.

It sure outperformed the cap-weight index in the last 5 years, or 10 years, but it did so by having more mad-cap in the index. The mad-cap index outperformed the cap-weight S&P 500 too.

Thanks for the responses. I should clarify a couple of things with respect to our Smart Indexing strategy. You are correct that by simply equal weighting the stocks in a capitalization weighted index, you gain greater exposure to the smaller companies within that index. It is also true that small and mid cap stocks have historically exhibited greater volatility than large cap. This is exactly what is described in the article you referenced, and it is the approach used in the S&P 500 Equal Weight Index.

However, this is just one way to “equal weight” an index, and a simple one at that. By only equal weighting the stocks, you will inherently end up with arbitrary sector bets. Take a look at the sector breakdown for the S&P 500 Equal Weight Index: http://us.spindices.com/indices/equity/sp-500-equal-weighted. You’ll see that there are large bets to Financials, Consumer Discretionary, Industrials, and Information Technology. As such, you would still be subject to sector boom and busts, which we recently saw in both Financials and Technology.

Our Smart Indexing strategy attempts to remove these boom and busts by equal weighting each economic sector. We take a similar approach with respect to size and style (growth, core, and value). As a result, the combination we back-tested did in fact perform better, and with less volatility. This is for the period 12/31/1990 to today. And so far, the same has been true with our actual results since launching in September of 2011.

I like how responses are handled by PC. Most times the author responds but at times the senior management also responds. Good work.

David @ Simple Money Concept
on April 23, 2014 at 11:35 PM

Hi Brendan,

Thank you for the clarification. I was talking about something else (equal-weight) this whole time!

However, now you have clarified it. I read the disclosure (I should have the first time,) and I noticed this: “Based on available data, the hypothetical results are time linked equal returns of size, style and sector indexes. From 1991 to 1995, it is an average of equal weighted S&P sectors and an equal weight of the S&P 500 and Russell 2000. From 1996 to 2011, it is an average of equal weighted S&P sectors and the nine Russell Style box indexes.”

It looks like the Smart Indexing strategy does have more mid/small cap? By the way, what was the beta for the period?

I also noticed this: “Standard deviation is only inclusive of full year return figures.”

If monthly return figures (as used by Morningstar) were used, was the standard deviation still less than the cap-weight S&P 500?

Either way, your actual result from 9/30/11 to12/31/13 is still impressive, and I’m all for lowering the investments fee. Keep up the good work!

Again, thank you for the clarification, and your further reply would be greatly appreciated.

One roadblock with simply indexing is emotion tends to kick in when the market is near a peak and REALLY kicks in when at a low. I’ve seen it over and over again…a lot of investors pour in big bucks near the peak and then sell near the low. If you have a good, competent, and experienced advisor, you likely avoid those common emotional mistakes. publicretirementplanners.blogspot.com

Smart-Beta includes strategies such as equal weighted portfolios. The idea is, when it rebalances once a quarter, it will sell the assets that went up, and buy the products that went down, and assume that all prices revert to the mean. This strategy has worked very well for the last 10-15 years, however historically there have been periods (like the 90s) when they would have been either just considerably lagged the market.

For example, quant techniques developed at Smart-Indexing.com superseded these other “smart-beta” techniques, but apply the same quant theories used at the very top hedge funds, however only at 1% management fee.

About the Author

Sam is the former Managing Editor of the Daily Capital…blog. He worked in finance from 1999-2012 before deciding to focus full-time on his online endeavors - FinancialSamurai.com and the Yakezie Network. Sam is an avid tennis fan who loves to travel. He received his BA from William & Mary and his MBA from UC Berkeley.

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